Equities rise but UK Health Secretary falls, what does this mean for markets?
I’ve been on holiday, so it’s three weeks since my last video…and a lot has happened! The US markets have hit record highs, oil prices have been strong, and sterling has been weak. Bond yields have fallen overall despite a markedly hawkish tone from the latest Fed meeting. Here in the UK, we have a new Health Secretary who has to deal with a big rise in new Covid cases, in marked contrast to the trends in other developed market countries.
Let’s begin with inflation … the big macro issue
Focusing on the US, we all expected a rise in headline inflation as base effects and the recovery took hold. But the scale of the rise has taken most people by surprise. Consensus expectations for core inflation in the US have risen markedly. The Fed have said repeatedly that they expect it to be transitory. Auto prices are a good example: demand has leapt as consumers spend their stimulus support money but supply is limited by the shortage of semi conductors. Rental companies are struggling to re-equip their fleets as air travel resumes and have bid up prices for nearly new used cars, and they’ve put their prices up as a result. As the US recovery has gathered pace these sorts of bottleneck price pressures have become more evident. More worrying for longer-term price pressures has been the pick up in the ‘shelter’ component, notably for housing rents. This is a big component of consumer prices and is likely to be more enduring. The Fed responded at their last meeting by recognising the risks and rowing back on previous more dovish statements.
If inflation were to take hold in the US, both bonds and equities would suffer. So far, the markets have been reassured by the hawkish Fed tilt: longer-term breakeven inflation rates have edged lower. I think the Fed have got it right but if we get more evidence that inflation pressures are building, the day when they begin to taper their bond purchase programme will be brought forward. Let’s see what news we get from the employment data at the end of this week.
UK Covid cases have risen, but so has testing
Meanwhile, back in the UK, new virus cases have risen markedly as a result of the easing of lockdown restrictions and the burst of the delta variant. Despite this, I do think there are good reasons to be optimistic. First, and most obviously, the success of the UK vaccination programme has weakened the link from new cases to hospitalisations and fatalities. The epidemiologists who advise the government were correct to forecast that new cases were set to soar when they persuaded the government to delay the final step of lockdown easing. But their modelling of the increase in hospitalisation – the key criterion – was way off. Instead of the projected rise to between 700 and 2000 a day, the numbers have stabilised below 250. There’s another important factor: the reported new cases greatly overstate the true rise in infections due to more testing. The more accurate random sampling by the Office for National Statistics does show a rise but roughly half as much as the more widely reported figures based on testing.
All this suggests that the new Health Secretary won’t have to delay the final stage of lockdown easing and the UK economic recovery can continue to build. Sterling fell heavily when the easing was delayed and should recover as the fears over the scale of the third wave subside.
European Recovery Fund – better late than never
Meanwhile, in Europe, the much-delayed Recovery Fund has leapt into action. This means big money in Southern Europe and is a substantial fiscal boost overall. More than year after the recession hit hard, it’s a case of better late than never.
All in all, the global economic recovery continues, led by the US and developed markets more generally, as Chinese economic activity eases and emerging markets overall struggle.
Equities have done extremely well this year and look set to continue to outperform. I struggle to see really strong performance from here – there’s an awful lot already priced in and economic momentum will surely slow from the US at some point. But I expect equities to outperform cash and bonds.